There are a number of ways that companies can boost earnings per share (EPS) to show earnings growth. The most obvious is by actually growing the business. Increasing top line revenue will translate into increased earnings, and increased earnings per share. Companies can also engage in cost reduction measures, allowing more of their top line revenue to pass through to earnings. A third, and popular method employed by today's corporations, is to buy back their own shares.
According to Data from TrimTabs Investment Research, corporate buybacks are at record levels. It's a trend that's been in place for many years, and it may be playing a strong role in driving the market higher.
There is a lot of chatter about "financial engineering" in the markets, and this is one example of that. When a company buys back its own shares, the number of outstanding shares declines. This has the effect of boosting earnings per share, even if the actual amount of earnings remains the same. Since earnings growth is typically measured by increasing earnings per share, this tactic can give the impression that a company is becoming more profitable, even if profits are stagnant
You can't really blame companies for doing this. Corporate management teams have a fiduciary duty to their shareholders to maximize shareholder value (profits). When a company is considering how to deploy capital, if buying back shares generates the best risk-adjusted return, it becomes the prudent thing to do.
One metric that comes into play in this discussion is earnings yield. The earnings yield is simple to calculate: it's the reciprocal of the P/E ratio. Instead of dividing a stock's price by its earnings per share to get the P/E ratio, you divide earnings per share by the stock price to get the earnings yield, expressed as a percentage.
For example if stock ABC is trading at $100 and has earnings per share (EPS) of $5, it's P/E ratio is 20 ($100/$5) and its earnings yield is 5% ($5/$100). An earnings yield of 5% implies that every dollar invested in that stock would generate EPS of 5 cents.
One important consideration is that earnings yield is volatile and can be somewhat unreliable. The earnings yield represents the earnings generated on capital during the latest quarter; it does not imply that future earnings yield will necessarily be the same. In general, the more stable a company's revenue and earnings are, the greater the likelihood that the current earnings yield will be indicative of future results.
Utilizing a forward earnings yield (same concept as above except applied to expected earnings) can make it easier to compare the potential returns of buying a stock versus other investments. It allows for a more apples to apples comparison, and it provides a measure of how much each dollar invested in a stock may earn.
If the management of a corporation is looking at a variety of options regarding where to deploy capital, and the forward earnings yield of their stock is among the highest and safest of those alternatives, repurchasing stock becomes a viable option and an efficient use of capital.
Taking this a bit further, there's an old line of reasoning that goes like this: If you can borrow money at 3% and earn a safe return at 4%, how much money do you borrow? The answer: As much as you can possibly get your hands on. This concept comes into play in many different areas of finance, such as currency carry trades, and is at the heart of why corporations are engaged in such a high level of buybacks.
[Read: Stock Market Drivers: Corporate Buybacks, Monetary Policy, and Large Institutions]
If a company can issue debt at a rate that is well below its forward earnings yield, it becomes a profitable venture for the firm to borrow at the lower yield and invest in its own higher earnings yield. We're seeing many companies engage in this type of behavior.
With interest rates so low and the cost of money so cheap, it almost becomes irresponsible for companies not to engage in this type of financial engineering.
According to Bloomberg, the biggest source of new capital buying up U.S. equities is coming from corporations repurchasing their own stock. Data compiled from S&P Dow Jones Indices, Bloomberg, and Investment Company Institute point to share buybacks outpacing customer deposits (inflows) to mutual and exchange traded funds at a rate of roughly 6 to 1 during 2014. Over $2 trillion has been spent by corporations on their own stocks since 2009.
Other data suggests that investors pulled out over $10 billion from equity funds during the first two months of 2015. This corroborates the declines we are seeing in NYSE margin debt and indicates that the market's continued climb is being supported in large part by corporations buying their own stock.
So is it time to worry? It's always time to worry. If you're not constantly a bit worried, you're not investing, because all investing involves risk. But this information should not, by itself, cause you to hit the sell button.
As mentioned above, corporations buying back their own stocks increases the value of each share, because each share now represents a larger portion of earnings. Companies heavily engaged in this practice have outperformed the broader market. In aggregate, the massive number of shares being repurchased stands a chance of boosting earnings growth in the quarters ahead, which is currently expected to be relatively flat, mostly a result of declining energy sector profits.
Regardless of who's doing the buying, the important thing is that someone is buying, and this is driving prices higher. We typically default to price action, and with most major indexes at or near all-time highs, it's evidently still a bull market. Proper positioning in a bull market is to be long to some degree. So while the information above is interesting, it doesn't negate the fact that prices remain in an uptrend, and the economic backdrop continues to improve.
